No Free Ride by NESsT

NESsT Learning Series

Acknowledgements

Written by: Loïc Comolli and Nicole Etchart Contributing writers: Shareena Mundodi Geoff Schwarten Francisco Silva Éva Varga Peter Varga

NESsT would like to thank The Rockefeller Foundation for its invaluable support in the preparation of No Free Ride: Sowing the Seeds of Impact Enterprises.

Senior researcher and project coordinator: Shareena Mundodi Research associate: Francisco Silva Content contributors: Roxana Damaschin-Tecu Gonzalo San Martín Mónica Vasquez del Solar NESsT Portfolio Managers Translation and copy edit support: Kerry Dudman Bill Gardiner Nicolas Mendoza Legal research contributions: Morales & Besa (Chile) Rebaza, Alcázar & De Las Casas (Peru) Graphic design and layout: Jorge Moraga

Acknowledgment also goes to the following institutions for their support and willingness to be interviewed for this report: Adobe Capital, Acumen Fund, Agora Partnerships, Artemisia, Avina Foundation, BBVA, CAF Venturesome, Carec, Citigroup, Corfo, E+Co, Eleos Foundation, Fondo de Inversion Social, Fundes, Grassroots Business Fund, Halloran Philanthropies, IDB/Fomin, Imprint Capital, Inversor, Invested Development, KL Felicitas Foundation, LGT Venture Philanthropy, New Ventures Mexico, Njambre, Omidyar Network, Pomona Impact, SEAF, Shell Foundation, Sistema B, The Ausherman Family Foundation, The Lemelson Foundation, Toniic, Village Capital, Vox Capital, and many more who are mentioned on these pages. And thanks to the global NESsT team and all of the friends and family members who provided support and nourished us throughout the process. It takes a village! Thank you!

Design contributions: Lee Davis and Alex Mendoza

SUMMARY OF FINDINGS AND RECOMMENDATIONS

Summary of Findings and Recommendations

Introduction Over the past decade, the impact enterprise1 development field has gained traction and is growing across emerging market countries. It is now evident that these enterprises have great potential to solve many problems for marginalized and vulnerable communities. Yet despite their demonstrated potential, impact enterprises in emerging market economies lack support mechanisms, alternative financing and an enabling environment for their development. Why have we not seen a steady and growing pipeline of impact enterprises?2 Where are the entry points along the pipeline that will facilitate the growth of these enterprises and deepen their impact? How can we close the gap between what stakeholders in the community would like to see from impact enterprises, and what these stakeholders are willing to support and invest to make it happen? No Free Ride: Sowing the Seeds of Impact Enterprise comprehensively maps and assesses the existing landscape and enabling environment of impact enterprise development in emerging market countries, as well as the support mechanisms and the best practices needed for impact enterprises to overcome barriers to development. Drawing on NESsTâ&#x20AC;&#x2122;s unique methodology for identifying and building the capacity of early-stage impact enterprises, as well as surveys of relevant stakeholders, this report provides a clear picture of where impact enterprises are, where they need to go, who the players in the impact enterprise field are, and how they can take the bold steps needed to facilitate the growth and impact of unique models. The report shows that there is no free ride. All stakeholders have a role to play if they are serious about impact enterprise development; they will all have to take on risks and incur costs if they want the field to mature. The road is not an easy one, but the findings presented in this report show that the road does exist, and it is very much worth going down.

no free ride: sowing the seeds of impact enterprise. summary of findings & recommendations Prepared by NESsT for The Rockefeller Foundation. Copyright ÂŠ 2012 NESsT.

1 NESsT defines impact enterprises as businesses that solve a critical social problem in a sustainable manner. NESsT invests in those enterprises that move marginalized communities out of poverty and exclusion by providing access to: fair employment, sustainable income; quality, affordable, basic services; improved living conditions; socially and environmentally responsible products & services; and universal rights. The working definition developed by the William Davidson Institute and chosen for The Rockefeller Foundation initiative defines an impact enterprise as a financially self-sustainable and scalable venture that actively manages toward producing significant net positive changes in well-being across underserved individuals, their communities, and the broader environment. Given the compatibility of the two definitions, for purposes of this report, they are used interchangeably. 2 For purposes of the research and this report, pipeline development is defined as activities taken by investors and incubators/accelerators to develop a stream of investment-ready and/or scalable enterprises.

SUMMARY OF FINDINGS AND RECOMMENDATIONS

Research Approach Definitions For the purposes of this report, NESsT uses both its own definition for impact enterprise as well as that of the Rockefeller Foundation research initiative. NESsT defines impact enterprises as businesses that solve a critical social problem in a sustainable manner. NESsT invests in enterprises that move marginalized communities out of poverty and exclusion. The working definition developed by the William Davidson Institute and chosen for The Rockefeller Foundation initiative defines an impact enterprise as a financially self-sustainable and scalable venture that actively manages toward producing significant net positive changes in wellbeing across underserved individuals, their communities, and the broader environment. Given that a major part of the research is derived from NESsT’s own portfolio and context, impact enterprise as defined by NESsT will be a main focus of this report. However, NESsT’s definition falls within the broader definition chosen for the initiative, and is completely consistent with the Foundation’s own interest in supporting underserved populations or communities. Particular emphasis will be given to early-stage impact enterprise development and the importance of strengthening support for early-stage growth. NESsT defines early-stage enterprises as enterprises that are 1-4 years into their development and show potential to be financially self-sustainable and scalable. The enterprise may be growing or replicating its model, but it is still not ready for pure market investment. Therefore it relies on patient capital (grants, soft loans, quasi equity) and non-financial support to get to the next phase of growth.

Geography NESsT focused the research on Latin America and Central Europe, the two regions where it has operated for over 15 years. In particular, the research focuses on Argentina, Brazil, Chile, Ecuador, and Peru, with some cases from other countries in Latin America including Colombia, Mexico and Central American countries. For the purpose of illustrating important models and innovative programs and policies, this report also highlights cases and experiences from Central Europe, particularly Croatia, Czech Republic, Hungary, Romania and Slovakia. There are also cases and 2

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policies from the European Union overall. Both Latin America and Central Europe are at important moments of change and show tremendous opportunity for adopting and adapting new models and practices locally, as well as sharing their experiences with the field on a global scale.

Methodology NESsT approached the research and analysis through a combination of portfolio analysis, desk research and interviews. It employed qualitative and quantitative analysis to identify, describe and evaluate the landscape, opportunities, trends and future path of impact enterprise development. NESsT’s experience with its portfolio of impact enterprises, as well as its efforts to build an enabling environment for impact enterprises in the regions where it works, has provided valuable documentation and analysis that will further develop the field. The experience of other actors working in Latin America who are developing financial and capacity-building support mechanisms for impact enterprises have supplemented NESsT’s analysis. A total of 683 entities were researched, 217 interviews were conducted, and 50 cases are featured in this report. The research was conducted by NESsT’s own team of senior managers with the support of a research and coordination team that was specifically designated for the project. The sections in this report include an in-depth description and analysis of the legal, regulatory, and policy environments that enable impact enterprise; donor practices, trends, and opportunities for impact enterprise development; analysis of a select number of pioneer donors who are offering new and innovative forms of support; discussion of incubators and their role in supporting and developing the pipeline; learning and best practices of early-stage impact enterprise scaling; an overview of the impact enterprise lending landscape and its use of mixed financial instruments; and the findings of a survey of early-stage impact investors. Opportunities and entry points are identified for each of these areas. The report emphasizes early-stage impact enterprise and the entry points that should be used in order to develop a healthy pipeline that can grow and have impact. Recommendations are offered in each of these sections, both for The Rockefeller Foundation and the field as a whole.

SUMMARY OF FINDINGS AND RECOMMENDATIONS

Section Summaries: Key Findings and Entry Points for Change Sections 2 & 3: The Regulatory and Policy Vacuum for Impact Enterprise in Latin America; Opportunities from Europe In Latin America there is no regulatory or legal framework recognizing impact enterprises, and impact enterprise is generally not part of any public policy debate. In the six countries researched, there is no specific legislation for either nonprofit or for-profit impact enterprise. In most cases, entities are created under existing legislation for associations, corporations or foundations (in the case of nonprofits), and for-profit limited liability companies (in the case of for-profits). Nonprofit impact enterprises typically do not pay income taxes as long as revenues generated go back to fulfilling the mission of the parent organization. This might differ from country to country as it relates to the type of entity; for example, in Chile nonprofit entities are required to pay the same corporate income tax as those of for-profits. In those cases where there is tax exemption, most of the countries do not have a threshold limiting the amount of tax-free revenues generated by enterprise activities. However, in all of these cases, these activities cannot be the principal purpose of the organization; if they are then organizations risk losing their tax exemption. This often causes concern on the part of nonprofit entities contemplating or already implementing enterprise activities. Nonprofit entities and their enterprise activities are typically subject to value-added tax. There are a few exceptions but they usually apply to direct social service providers. In most of these countries, interpretation of the law is left to the discretion of local regulators, which leads to uncertainty over how to treat impact enterprises. Regulations and associated bureaucracy are often regarded as excessive or encumbering. To add to the confusion, in some countries like Argentina and Brazil, a specific ministry often decides regulations and implementation, leading to discretionary and subjective treatment of the law. On the supply side, benefits for philanthropic giving are very limited. No individual tax deductions are allowed in most countries; corporate tax deductions are limited to certain sectors such as culture or education. And yet there is little appreciation for the “government savings” derived from impact enterprises. 4

SUMMARY OF FINDINGS AND RECOMMENDATIONS

Some players in the field say that the irony of having no specific legal framework to operate in keeps the door open in terms of experimentation and creativity with impact enterprise format and financial instruments. Although this leaves room for innovation, it can also lead to overall misinterpretation or provide fodder for those who already mistrust these initiatives. Labeling has come to the forefront of impact enterprise in the European Union, and an entry point to influence change in Latin America would most certainly be adopting Sistema B (B-Corporation) certification. Efforts to do this are slowly gaining traction in Argentina, Chile, and Colombia, and soon in Brazil. This is a positive development because it raises the visibility and importance of the sector, but it could be worrisome if it leads to the exclusion of innovative models that fall outside of given parameters. Another important entry point could be taking cues from the Social Business Initiative (SBI) in the European Union, which plans to channel a EUR 90 million facility that will be used to create funds leveraging additional private capital. It will be used to invest in or co-invest with financial intermediaries (i.e., impact investing funds) through various types of financial instruments such as equity, quasi-equity and debt instruments, plus portfolio guarantees. The SBI also calls for a “social enterprise label” for impact enterprises to qualify for European Union funds, which would enhance private investment confidence and make micro-credit programs available for social enterprises. On the non-financial side, SBI focuses on raising the visibility of social enterprises in the region and on developing best practices, training and exchange platforms to professionalize the sector. A final entry point is the use of government procurement programs in both regions that attract capital to impact enterprises and provide potential for scaling. They may exist along sector and territorial lines.

Section 4: Donor Giving and Impact Enterprise in Latin America – A Fragmented Landscape An extensive analysis of NESsT’s past, current, and potential donors in Latin America in the past ten years reveals that support for early-stage impact enterprise development is for the most part scarce and fragmented. The database of 230 donors, including international and national foundations, corporations, banks, government agencies and high net worth individuals, shows that while 73 have supported NESsT’s work to develop impact enterprise in the region, only 25% explicitly recognize this support. The remaining 75% support these efforts through other programs, mainly economic, community and social development programs. They see impact enterprise no free ride: sowing the seeds of impact enterprise. summary of findings & recommendations Prepared by NESsT for The Rockefeller Foundation. Copyright © 2012 NESsT.

SUMMARY OF FINDINGS AND RECOMMENDATIONS

3 Results of this research can be found in NESsT Country Assessments published for Argentina, Chile, Colombia, Ecuador and Peru.

development as having an added value to their existing programs but have not chosen to explicitly develop a grant program for the sector. The levels and duration of funding have been relatively low for the most part. Only 22% of donors have given donations of USD 100,000 or more, and the rest have provided lesser amounts. Only 22% of donors have committed for more than one year, with the rest committing for one year only. Of those committing for one year, 18% have become repeat donors, typically for no more than 3 years. Only a handful of donors have committed USD 1 million and for a period of 3-5 years. These practices demonstrate that although there is an interest in supporting early-stage impact enterprise development, the donors are not yet ready to provide significant support for these ends. These results were corroborated from interviews of over 40 institutional donors that NESsT surveyed when entering countries in the region over the past five years.3 Although the majority felt that building sustainable impact enterprises was critical, they admitted that they were not funding these efforts due to their own funding constraints. NESsTâ&#x20AC;&#x2122;s own work with civil society organizations (CSOs) in the region demonstrates that very few donors develop exit strategies for their grant-making. There is a resistance to covering operational costs, a critical aspect of growing impact enterprises, and a tendency to focus on very short-term results. This sets up unrealistic overall expectations for the sector and the region as a whole. Yet in spite of these barriers it is important to recognize the vital role that donors have played in recognizing this as an area worth supporting. Currently donors are really the only funding available to launch and grow these businesses in the region, since very few impact investors operate at the startup or early-stage phases. The fact that donors are willing to do so is important and provides a platform for figuring out how to expand this pool. Perhaps the most evident entry points emerge when understanding what impact enterprise areas different types of donors tend to support. It is in the areas where they have already shown commitment where they are most likely to continue to grow. Some of these trends have started only recently, in the case of some forward thinking government agencies and corporations. Foundations should continue to fund capacity support and innovation, to foster new thinking, demonstrate models, and disseminate tools, methodologies and best practices. They should also support the infrastructure for impact enterprise (e.g. events, incubators/accelerators), business planning and startup phases.

no free ride: sowing the seeds of impact enterprise. summary of findings & recommendations Prepared by NESsT for The Rockefeller Foundation. Copyright ÂŠ 2012 NESsT.

SUMMARY OF FINDINGS AND RECOMMENDATIONS

Corporations and financial institutions need to build this into their core businesses. They shouldn’t see impact enterprises as a mere side activity of their charitable activities, but rather part and parcel of their overall business impact. They should continue to support earlystage pipeline building through business plan competitions and launches. Corporations should enter communities assessing the potential to develop impact enterprises in the regions and sectors where they are operating. There is no doubt an opportunity here to develop impact enterprises that can offer products and services needed by parent companies, as well as by the communities they serve. Support for these enterprises can be given by the companies themselves—if it can be long-term—and in some cases outsourced to incubators or other entities that can offer this expertise. Bilateral and multilateral agencies should include impact enterprises in the projects that they support and start supporting intermediaries that can play an important and cost-efficient role in developing these enterprises. Family foundations, family offices and HNWIs should continue to provide the flexible funding that is often needed at incubation and later stages of the impact enterprise development process. Entities that support and conduct research can play an extremely important role in developing the knowledge needed to assess what works and to influence policy and awareness-building on behalf of the impact enterprise sector. Finally, the experience of NESsT’s Private Equity Shares Program presents an example of creating philanthropic products for a specific industry as a way to unlock new donations for impact enterprise. The affinity of the impact enterprise development approach with the way that the industry operates has made private equity interested in becoming engaged, which offers insights on how to do this with other industries. Donors should work together to leverage resources and maximize impact. They need to invest in local philanthropy and investment for impact enterprise in the region. They should try to reach a certain degree of consensus around what is needed to build the appropriate infrastructure and policy, and continue to engage practitioners in these efforts.

Section 5: Betting on Higher Social Returns – Pioneer Donors Show the Way The concept of “engaged” philanthropy provides a hybrid approach to giving that integrates the philosophy and practices of longterm investment and venture capital with the grant making principles of the non-profit sector. Some “pioneering” donors committed to long-term impact enterprise support are using this hybrid approach to catalyze the field and no free ride: sowing the seeds of impact enterprise. summary of findings & recommendations Prepared by NESsT for The Rockefeller Foundation. Copyright © 2012 NESsT.

SUMMARY OF FINDINGS AND RECOMMENDATIONS

play a leading role in filling in some of the current gaps in the marketplace. Pioneers demonstrate leadership in their country or sector, or through the approach they use to support impact enterprise; they are role models for other entrants to follow. A survey of 13 of these pioneer philanthropists and investors—selected for the research because they either have a relationship to NESsT operations, work in Latin America or demonstrate a replicable capability that could provide guidance for emerging or maturing regional donors/investors—sought to understand pioneers’ primary objectives and mission, as well as their broad strategy in the impact enterprise field, financial instruments employed, capacity support initiatives, important partnerships or networks, and efforts at field-building. These are all critical ingredients for strengthening the impact enterprise sector. Pioneer donor best practices provide the entry points for new entrant donors in Latin America. Specifically, these best practices are patient capital, tailored financial instruments, capacity support, increasing deal flow, and field development. Patient capital is a trademark of pioneer donors who take a long-term outlook to impact enterprise development. Pioneers view patient capital and long-term investment horizons as a way to increase impact. In many cases, supporting early-stage impact enterprise development entails risks that take time to recognize and overcome. Failure is inherent in the process and developing lessons learned and making the necessary adjustments with impact enterprises takes time. Pioneer donors assess their support and exits over a 10-year time frame. Tailoring financial instruments to find the appropriate fit between an impact enterprise and the range of financial tools available is critical for pioneer donors and investors. Grants are typically made alongside investment support to early-stage enterprises that require some subsidy or capacity-building assistance in preparation for scaling social impact. Pioneers view their role as preparing impact enterprises for impact investors (though many are still too risk-averse for the early stage) and innovating with new financial instruments to help other donors and social investors move into this sector. Capacity support is a standout element of pioneer support for impact enterprise. Pioneers see capacity support as a critical component for impact enterprises to reach self-sustainability. Business advice, market access and governance support always complement (and protect) financial investments, in order to create resilient impact enterprises with growing confidence for expansion and scaling. Increasing deal flow is a challenge for pioneer donors. Pioneers focus on how to grow the pipeline through the development and 8

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expansion of incubators and accelerators. Partnerships and leveraging expertise from different sectors are critical to foster collaboration that can increase the emergence of both impact enterprises and impact investors. Field development is viewed by pioneers as part of their responsibility to grow the impact enterprise sector. Support for initiatives such as B-Corp and SOCAP, which increase the enabling environment, are important components. Knowledge building, in the form of case studies and sharing of lessons learned, increases awareness about impact enterprise and helps to develop international best practices. Advocating for more conducive public policies falls under field development and includes working with governments to design policies to foster the emergence of impact enterprises and to channel government resources to fund the sector. CORFO, the government entity in Chile promoting entrepreneurship and innovation to improve productivity in the country, is an example of a pioneer in the field of public sector donors: it is one of the few government agencies in Latin America to pilot support to impact enterprises. CORFO runs an Innovation and Social Entrepreneurship Competition, which funds projects promoting social entrepreneurship. CORFO piloted the program this year and has found its two main challenges to be creating measurement instruments—since the government agency needs new tools to measure impact enterprises’ social impact— and creating a coherent terminology for the field, as there is a lack of awareness about impact enterprise and social business in Chile. The Lemelson Foundation is another pioneer donor in Latin America. The family foundation supports inventors and entrepreneurs building invention-based businesses that either create products that satisfy basic human needs, or enhance the ability of the target populations to create and manage income (i.e. agriculture, etc.). The Lemelson Foundation places a strong emphasis on capacity support, which it sees as critical to building self-sustaining organizations. Furthermore, capacity support is a means to an end: it achieves sustainability for organizations or businesses that can exist permanently as “agents of change” in the ecosystem in which they operate, becoming role models for public/private sources. As a moderately-sized foundation, it believes it can tackle the early-stage challenges more effectively, since often large foundations and governments are not able to adapt the size of their investment to the needs of the impact enterprise. The Lemelson Foundation’s approach is to support enterprises early and take big risks. It recognizes that a return on “inventiveness” does not happen quickly, or without patience. Building and promoting technological innovation will see a return in a 10, 20, or 30-year timeframe.

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Section 6: Incubators – The Pipeline Builders for Impact Enterprise A thorough scan of incubators in Latin America suggests that while there are several hundred business incubators, particularly in Mexico and Brazil, there are few that are directly linked to impact enterprise (less than 20). NESsT focused on a few early-stage impact enterprise development incubators (Agora Partnerships, Artemisia, Fundes, Njambre, and NESsT’s own operations) in order to understand variant methodologies, challenges, and the need for philanthropic capital, not only for the portfolio enterprises they support but also for their own expansion, operation and sustainability. These incubators help entities realize business plans and financial self-sustainability, and set the stage for scaling or replication. Incubators provide a link between entities, market they operate in, and the potential investors who can provide more long-term capital and support. NESsT supports the development of three types of enterprises: those owned by civil society organizations (CSOs), small and mediumsized for profit impact enterprises (SMFPIEs), and grassroots technology innovators. NESsT employs a portfolio strategy and provides support to impact enterprises in three distinct phases: business planning (after 9-12 months), incubation (in years 2-4), and scaling (in years 5-8). Each phase builds upon the former, and each has specific goals and indicators assessed by the portfolio member, the NESsT enterprise development team, and external advisors. Opportunities to apply are disseminated widely on a yearly basis. On average, 40-50 applications are received, and of every 15 that enters planning 4-6 will be incubated and 1-2 will go to scale. The majority of incubated enterprises will exit upon consolidation (i.e., they do not move on to scaling). Those very high performers with a strong scaling strategy and potential will be invited to scale. NESsT provides support to its incubation portfolio members in the form of financial capital, training and mentoring. Financial support is typically provided in multiple installments of grants and/or loans for start-up or working capital, tied to specific benchmarks in the business plan. Each portfolio member receives on average 34 days of capacity-building support each year. In-house capacity support is complemented by external support provided by accomplished subject matter experts.

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NESsT works closely with its portfolio to develop a set of metrics and indicators to measure capacity gained as well as performance and impact. The ACCESS Tool captures skills and know-how at the planning stage. The Performance Management Tool is used at incubation to manage and measure impact in four main areas: enterprise performance, social impact, institutional development and financial sustainability. Evaluations are conducted every four months, and an annual evaluation determines if the portfolio is ready to exit. Since the beginning of NESsT’s impact enterprise development program, 621 organizations and innovators have received capacitybuilding support in the planning stage, of which 118 have made it into the incubation stage. That is a 19% success rate in passing rigorous due diligence and business planning standards. NESsT has learned multiple lessons from this process. First, it is possible to effectively adapt the impact enterprise development methodology to the target group, level of entrepreneurship and leadership, as well as advance the business idea. However, to be useful and reliable, impact measurement needs to standardize metrics, while also providing room for some customization which will allow for maximum possible input from management to ensure buy-in. A successful approach to impact enterprise development is almost by definition a comprehensive one. This oftentimes means not only working on the micro-level, i.e. with impact enterprises, but also on the meso-level (supporting value chain and sector development, or supplier associations) and macro-level (lobbying and advocacy on behalf of enabling legislation and growth conditions). The latter two are very important when incubating, and especially when scaling. Ability to work on an enabling environment as well as providing relevant services to impact enterprises necessitates an intimate and wide-ranging familiarity with the local conditions, cultures, legislation and language. NESsT has always insisted on employing local staff with excellent local knowledge, networks, and language proficiency. The fragmented linguistic as well as geographical conditions that arise from being locally embedded doubly require consciously collecting and cultivating knowledge, best practices, and adaptable solutions. Each of the other four models studied offers unique features and lessons for working with early-stage impact enterprises. Agora Partnerships works principally in Mexico and Central America. Its mission is to “accelerate the growth of early-stage companies throughout Latin America that create positive impact.” Impact enterprises selected by Agora Partnerships enter a six-month program that trains them to attract interest from impact investors. Agora Partnerships is developing a network of contacts to make it easier for investors to contact entrepreneurs or attractive impact enterprises. no free ride: sowing the seeds of impact enterprise. summary of findings & recommendations Prepared by NESsT for The Rockefeller Foundation. Copyright © 2012 NESsT.

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Artemisia, founded in 2003 by Potencia Ventures, provides incubator and accelerator services for impact entrepreneurs in Brazil looking to streamline their business approach and become investable. It recruits up to 10 enterprises per acceleration cycle. On average, 60% receive investment. Artemisia’s goal is to not only provide technical assistance to portfolio members but also to leverage its networks among investors. Artemisia tends to steer away from organizations that do not have large-scale impact potential. While not exclusively an impact enterprise incubator, Fundes does provide capacity and network support to its target micro-, small and medium enterprises (MSMEs) to ensure access to fair wage employment and better work conditions. Fundes intervenes during the growth stage of MSMEs, helping them to access and sell their products for an agreed upon price to an anchor company by providing access to finance, knowledge and markets. This intervention takes 1-3 years, with Fundes balancing the initial relationship between the companies and producers. A very interesting component of the Fundes model is that the companies pay Fundes for this service. The Njambre Accelerator program supports companies developing sustainable impact enterprises. The accelerator program lasts six months, during which a business plan is developed in order to help the company achieve its full potential social and/or environmental impact. Njambre believes that there are not enough enterprises addressing social problems or critical environmental issues. It recognizes that access to patient capital for early-stage impact enterprises is limited. Entry points for development of incubators in Latin America are numerous given the very low maturation stage of the field. There needs to be a shift in philosophy among both incubators and investors to focus more efforts on supporting impact enterprises at the early stage, rather than solely on those that have established business practices. Soft funding needs to be provided to help incubators bear the costs of capacity support and patient capital of early-stage impact enterprises. There needs to be better communication between companies and impact investors. Currently there is no platform or organization fulfilling this role, so investment opportunities are often lost. The incubators must cultivate investors and educate them on the promising future of impact enterprise— which has a cost—while at the same time looking for investment opportunities. More investment in networking and communication channels should go toward connecting the pipeline of opportunities with donors and investors. 12

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Incubation initiatives in universities should help to move enterprise ideas beyond theory and “graduate” them from academic circles to help them access the market. The state can play an important role in developing the infrastructure of impact enterprise incubation. CORFO has already begun to take steps in this direction. However, it is important that these efforts not be overtaken by bureaucracy or narrow definitions of the impact enterprise sector. Long-term support of incubators is vital if those entities want to scale, replicate, and become self-sustainable. Artemisia’s 9 year track record is allowing it to expand to northeast Brazil to reach more needed populations. NESsT’s 15 years has allowed it to learn, improve upon its tools, and replicate to ten counties. Given the need to accelerate the growth of incubators themselves, there is a need for investment in systemizing, as well as sharing existing best practices, methodologies and tools, and replicating them.

Section 7: From Idea to Scale – Scaling Early-Stage Enterprises To identify the key ingredients, support and best practices needed to select, grow and scale early stage impact enterprises, NESsT benchmarked and assessed its own portfolio. It documented the process in order to demonstrate the incremental and not so obvious steps needed to go from idea to scale. The first step to reach scaling goals is to have clarity on what is being scaled. For NESsT, the focus is on three impact areas to improve the lives of marginalized communities through labor inclusion, sustainable income and grassroots technology. Given the strong mission focus and the many social costs of these enterprises (e.g., social dimensions of the businesses), the increases are incremental and aim to reach 1,000-30,000 marginalized persons in the period of three to five years. The next steps are due diligence and selecting the scalable enterprises. Not all portfolio enterprises are scalable, and the process to make them scalable requires a significant investment of resources, as well as asking the right questions at the appropriate time. Ensuring that all of the factors and drivers are lined up requires having a very close understanding of the scaling candidates in the incubation stage. NESsT identified 16 impact enterprises in its incubation portfolio of 70 as potential scaling candidates. Through a rigorous selection no free ride: sowing the seeds of impact enterprise. summary of findings & recommendations Prepared by NESsT for The Rockefeller Foundation. Copyright © 2012 NESsT.

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process using performance indicators, eight were selected for scaling, four were asked to take six months to further consolidate and become scalingready, and four were asked to continue with incubation. The eight selected for scaling met a hierarchy of scaling goals including strong leadership and management, performance orientation, a strong fit and value added with NESsT, and a commitment and opportunity for scaling. In all four consolidation cases, strong leadership and management were missing and resources are currently being invested for this to be strengthened. In the case of NESsT, having an existing relationship (of at least two years of incubation) with the enterprises provides an appetite for risk that others might not have, nor even be aware they lack. Balancing this relationship with objective decision making is vital. Having a large pipeline of 70 incubation enterprises to benchmark is definitely an asset. Although many investors would like to circumvent the process of building a large pipeline, the need to do this becomes even more important in the case of impact enterprises, given the difficulties in running businesses with high social costs and potential risks and the patience required to overcome these challenges. The third step in scaling is choosing the right scaling strategy. This is critical but not always easy when assessing socially-focused enterprises. NESsTâ&#x20AC;&#x2122;s framework includes growth replication and policy adoption strategies. There are often program costs (for example relating to training marginalized groups employed in the enterprise) that need to be considered which make economies of scale and business efficiency difficult. However, reducing these costs significantly could compromise impact, since the enterprise may not reach its intended beneficiaries. Offsetting some of the initial costs through grant funding is an important consideration. The need to keep scaling strategies simple by adopting the right business model is also important. A textile business that requires high production output might not be suited for the employment of marginalized communities whose productivity might be limited. Another extremely important factor is the degree to which the enterprises can scale through the adoption of new attitudes, behaviors and policy. In all eight scaling cases from the NESsT portfolio an adoption indicator was identified and built into the strategy. The fourth step in the scaling process is determining the right levels and type of capacity support. As is the case with incubation, capacity support is fundamental but the type of support provided needs to be more strategic, specialized and time sensitive, and requires a well-consolidated management team to quickly adopt and apply it. The relationship between the Portfolio Manager and the Impact Enterprise Manager needs to evolve into one of complete trust, where the mentoring and guidance provided is valued and used wisely. For the investor scaling an impact enterprise, 14

no free ride: sowing the seeds of impact enterprise. summary of findings & recommendations Prepared by NESsT for The Rockefeller Foundation. Copyright ÂŠ 2012 NESsT.

SUMMARY OF FINDINGS AND RECOMMENDATIONS

the question of control of the business may be less relevant than in venture capital or private equity, and influence through persuasion and trust may be more relevant. NESsT conducted an assessment of 20 cases of scaling outside of its portfolio that identified specific leadership, business, and enabling environment best practices for scaling. Perhaps the single most important business practice is to develop a multidisciplinary team that can meet the demands of scaling. Itâ&#x20AC;&#x2122;s also necessary to build strategic alliances and leverage contacts, networks, expertise and resources of a larger group. Building these will increase the likelihood of scaling innovative products when there are no regulations and processes in place to recognize and mainstream them. Deciding what should be systemized and what should be tailored to the needs of each impact enterprise will also be important. Early stage impact enterprise financing decisions should be made based on capacity to help enterprises achieve their impact. Although the ability to repay or offer a return is important in selecting the right financial instrument, the main drivers should be: the purpose for which the financing is sought; the type of risk that is tied to the instrument; performance indicators including the historical and expected social impact and income growth of the enterprise; and external considerations such as the supply and type of capital available. There are many entry points for successful scaling. Investing in the methodology and tools that are specifically appropriate for scaling impact enterprises is fundamental. There are very few tools available, and those that do exist, mostly standard industry tools for scaling, are only appropriate for later stage enterprises. Providing support to the incubator or scaler in building its knowledge management systems is important because the team will need to have ready and timely access to information, best practices, tools and systems, contacts, and networks. It is also critical to train portfolio managers for scaling. Skills and know-how relevant to incubation are quite different from those that are relevant to scaling. Most incubators and accelerators lack scaling experience, and yet in many ways they are the ones best suited to lead early stage impact enterprises on a path to scale. Financial resources for consolidation and growth grants, as well as for leveraging experts, alliances, and public relations are fundamental. Support also needs to be provided for experimentation and cross-learning. Resources need to be allocated which allow no free ride: sowing the seeds of impact enterprise. summary of findings & recommendations Prepared by NESsT for The Rockefeller Foundation. Copyright ÂŠ 2012 NESsT.

SUMMARY OF FINDINGS AND RECOMMENDATIONS

for some of these to be piloted so the industry can learn from failures and success. Documenting these experiences and disseminating lessons learned will help to reduce risks and to identify the fundamental ingredients that need to be in place for more scaling success.

Section 8: The (Stair)case for Mixed Financial Instruments NESsT research of the landscape in both Central Europe and Latin America in the past five years demonstrated very few financing instruments available for impact enterprises to fund their startup, consolidation and growth. A total of 67 CSOs and impact enterprises on the demand side of capital and 58 financing institutions on the supply side were interviewed. For the demand for capital, the use of financing instruments other than grants has been hindered by a fear and lack of understanding by impact enterprises themselves. The lack of supply from the finance sector has also been apparent. Banks and investment funds in emerging market countries have not considered impact enterprises as a business opportunity, partly due to the small size of the sector and lack of appropriate due diligence tools. NESsTâ&#x20AC;&#x2122;s survey of its portfolio in Central Europe revealed that although most organizations still prefer grant funding, half already considered applying for a loan, 29% did apply for a loan, and 25% already took out a loan. Those that obtained loans got them from commercial banks where they had personal contacts and thus a better chance of getting their application approved. The biggest challenges in the lending process were filling in the required documentation and meeting the bankâ&#x20AC;&#x2122;s criteria. Collateral was a typical concern, but high interest rates, additional costs, and no adjustment to impact enterprise specifics were also listed. Concerning their future plans, half of the impact enterprises surveyed in Central Europe said they would consider applying for a loan and 90% said they would welcome a newly established specialized loan fund for impact enterprises. In Latin America, despite the presence of a micro-finance sector and the apparent openness of banks to offer loans to impact enterprises in the region, there are few actual experiences of impact enterprise lending. Again, a CSO preference for grants, complicated risk assessment processes, lack of collateral, and lack of creditworthiness were cited as the main causes. Paradoxically, limitations on asset-building imposed by donors contributed to the lack of creditworthiness. Very few alternative loan funds were identified. Those that exist tend to offer bridge loans only, or offer loan amounts that are often higher and costlier than the amounts needed by impact enterprises. They 16

no free ride: sowing the seeds of impact enterprise. summary of findings & recommendations Prepared by NESsT for The Rockefeller Foundation. Copyright ÂŠ 2012 NESsT.

SUMMARY OF FINDINGS AND RECOMMENDATIONS

tend to focus on traditional social sectors and in most cases these are not accompanied by any kind of capacity support. One exception is Tise in Poland that has made many loans to CSOs and impact enterprises, requiring loan guarantees of only 20%. Most banks do not consider impact enterprises a big enough target group to approach or to develop special loan products for, particularly during a recession when most of their clients are cut off. Market conditions are often inadequate for startup or development of early stage impact enterprises due to the “social costs” attached to their activities. Interviewed banks did not seem to take this under consideration. To fill this gap, NESsT decided to pilot loan and equity investments to complement its grants to the portfolio. Different loan instruments were provided to the portfolio for different purposes, including bridge loans, infrastructure loans, startup, operations and growth. In some cases this was done with NESsT´s own donor funds and in others with third party lenders. Amounts ranged from USD 4,300 to USD 55,000. Loan repayment ranged from six months to six years. Soft lending terms were applied in all cases, with interest rates ranging from 1% to 17% depending on the country and funding source. Repayment has been on track in all cases except one. In almost all cases, grant financing from NESsT prepared the impact enterprise for stepping up to the next level of funding, and in some cases a loan or equity investment was directly combined with a grant to make it more effective. In the case of Kek Madar, a social enterprise in Hungary, a grant supplemented a loan for the purchase of a building to expand their restaurant, which in turn leveraged grant funding from another donor for refurbishment. For Fruit of Care, another social enterprise in Hungary, a grant, loan, and equity investment was made to grow the business, with each financial instrument serving a different purpose. Experience shows that loans can be used for different purposes and at different stages, both during incubation and scaling. However, the lesson of Popular Safi, the NESsT loan fund set up to extend loans to grassroots technology startups, shows that loans are not the best instrument for startups since there is no cash flow and repayment capacity. Equity investments continue to be the least common form of financing for impact enterprises, not only in Central Europe and Latin America, but in more developed markets as well. First, there is a lack of investable opportunities, partly due to the small pool of investees, and partly because of the mismatch in size of the investments and investees. A lot of investors are looking to place large amounts of capital to cover their costs and receive a financial return that the majority of impact enterprises are not yet ready to absorb. Many investors also consider it another funder’s no free ride: sowing the seeds of impact enterprise. summary of findings & recommendations Prepared by NESsT for The Rockefeller Foundation. Copyright © 2012 NESsT.

SUMMARY OF FINDINGS AND RECOMMENDATIONS

job to make sure that the impact enterprise is investment ready, i.e. they are not willing to pay for capacity building or startup costs (first loss). There is a mismatch in the market. Profitable impact enterprises are often legally not allowed to pay dividends and therefore financial return can only be realized upon the decision of shareholders to sell their shares. At the moment, there are no secondary markets presenting exit opportunities for current equity investors, since the industry is still very young. There are many entry points for mixed financial instruments. The research and lessons from NESsT pilots and practical experience, demonstrate that grants, loans and equity have a very specific role to play in the development of impact enterprises and when used wisely, can be the key driver to success. Debt finance helps appropriately finance the incubation and later the expansion/scaling of impact enterprises. Additionally, it leverages funds from third party lenders to complement grants. Finally, it helps professionalize impact enterprises and makes them ready for debt financing and investment from the market. The role of grants in mix financing instruments is fundamental. They provide badly needed funding for startups and new ideas, they pay for costs investors are not willing to absorb (e.g., social costs of the business), they help build trust between impact enterprises and donors, they help obtain proof of concept, they make other financing instruments more effective, and they can be extremely useful when testing new ideas once the impact enterprise has consolidated. At the same time, grants do not always provide the level of influence to make the management and governance changes needed. Developing greater levels of influence, sometimes through equity investment, should also be considered. Considering that determining the interest rate is not always easy, there needs to be a process in place that balances the need to offer soft conditions, teach borrowers about the cost of money, and cover some of the costs of lending. NESsT pilots demonstrate that when done carefully, borrowers are able to repay softer term loans and to transition to the commercial bank sector. The investment readiness stage is critical, and lenders and investors must take a role themselves by perhaps accompanying their financial investment with direct provision of capacity support to the impact 18

no free ride: sowing the seeds of impact enterprise. summary of findings & recommendations Prepared by NESsT for The Rockefeller Foundation. Copyright ÂŠ 2012 NESsT.

SUMMARY OF FINDINGS AND RECOMMENDATIONS

enterprise, or providing that capacity support through an intermediary. Naturally, such intermediaries need funds and resources to operate and further develop their investment readiness programs. Expectations of financial return need to be reconsidered; lenders and investors in impact enterprises must be ready to accept realistic (lower) returns in exchange for high social impact. Smaller and medium-sized impact enterprises that do not have a credit history but can show that they can repay a loan could start developing a track record through intermediaries by experimenting with loans when appropriate. These intermediaries could offer products to impact enterprises working in certain fields of activity that banks are less likely to support, for example human rights, democracy building or environmental issues. They could also offer guarantees to help new enterprises obtain debt finance from mainstream institutions. A market between startup and current impact investing needs to be developed that allows early stage enterprises to transition and slowly begin to scale. Amounts from USD 50,000-300,000 are critical in this market and can be a mixture of grants, loans and equity. Finally, incubators in the field must realize that there are unexplored opportunities in partnering with funds and investment programs in Latin America to help prepare impact enterprises for alternative financing from these entities. Third party financing is efficient and cost effective when large amounts are required.

Section 9: Second Fiddle, Third Wheel â&#x20AC;&#x201C; Early Stage Impact Investing in Latin America There are relatively few early-stage impact investors operating in Latin America. Those that do exist have just recently set up their funds, are starting their due diligence process, and/or have recently started making investments. Early-stage impact investing in Latin America is just beginning. NESsT screened 166 impact investors globally that are deploying capital to impact enterprises to determine what stage they participate in (seed-early), the size of their investments (USD 500,000 or less), and their locations (operating in one or more Latin American country). Following this screen, 34 investors were selected for further research, and 17 were interviewed with an in-depth questionnaire.

no free ride: sowing the seeds of impact enterprise. summary of findings & recommendations Prepared by NESsT for The Rockefeller Foundation. Copyright ÂŠ 2012 NESsT.

SUMMARY OF FINDINGS AND RECOMMENDATIONS

Latin America presents an interesting environment for impact investors. From an investment perspective, Latin American economies have grown at a much healthier pace than the sluggish economies of the U.S. and Europe. On the flip side, this economic growth has caused many international aid organizations to move away from Latin America—despite the many social problems in the region including a weak civil society sector, wide disparities in wealth and income, and a lagging educational system—due to greater needs in Africa or Asia. Latin America presents opportunities for impact investors, and they can meet an identified need in terms of capital provision to tackle social issues. International impact investors that focus on more than one continent generally cite India and Africa as top investment destinations, with Latin America a third priority. Though not currently very active in the region, international impact investors interviewed for the research say they plan to increase their presence in the region over the next three years. One of the top ongoing concerns for impact investors in Latin America is how to exit an investment. Investors across the board pointed to how Latin American capital markets are less developed than those in the U.S. For the most part, an exit in Latin America would consist of a buyout by a larger corporation or a successful repayment of loan obligations. A greater number of impact investors operating in the region would help early-stage investors exit their investments more rapidly. Over the next few years, documenting and highlighting exits will be crucial to the success of impact investing in the region, especially since most early stage funds operating are new or fairly new, and case studies will help to assess successes down the road. Investors in Latin America use a range of investment vehicles such as debt, equity, and hybrids such as mezzanine debt. Convertible debt is the most frequent option with early-stage impact enterprises, given the lack of cash flows to service traditional debt and the high transaction costs of equity in relation to small deal size (impact investors also cite the lack of exit opportunities as a factor in preferring convertible debt over equity). There is a near unanimous sentiment that incubators and accelerators are a potential source of investment deals. A few incubators/ accelerators were universally recognized in interviews, potentially oversubscribed in terms of investor interest. This shows the need for impact investors to have access to a greater network of impact enterprise incubators/ accelerators. Impact investors operating in Latin America recognize the need for capacity support to early-stage impact enterprises. Investors have varying strategies to provide capacity support, which includes participating in strategic planning with the enterprise and tapping investors’ networks. 20

SUMMARY OF FINDINGS AND RECOMMENDATIONS

Impact investors have also successfully partnered with incubators and accelerators to share the costs of early-stage capacity support, and these cases should be documented and promoted widely. Impact investors benefit from government policies enacted to support general investment, specifically venture capital investment. For example, in Colombia, Ecuador, and Mexico, impact investing funds and impact enterprises have received government financial support, demonstrating the potential role that government programs and regulations can fill in catalyzing resources for impact investing in the region. At the same time, navigating the multiple regulatory environments can be challenging for impact investors. Some countries such as Brazil heavily regulate and tax foreign direct investment, increasing transaction costs. The entry points for promoting impact investing in Latin America include the following: •

Encourage the development and expansion of incubators and accelerators, as investors rely upon Latin American incubators and accelerators like Agora, New Ventures, and Artemisia.

•

Reduce transaction costs for impact investors by providing comprehensive legal and investment guides for navigating the investment climate in the many countries that comprise Latin America.

•

Increase the profile of the region as an attractive investment destination for impact investors by documenting and disseminating case studies of successful impact enterprise exits. Documenting and sharing new innovative investment vehicles would also accelerate the development of the industry.

•

Promote the emergence of new funds in countries/regions where there are noticeable gaps in the early-stage pipeline for impact enterprise investors, specifically in Chile, Colombia, and parts of Central America.

SUMMARY OF FINDINGS AND RECOMMENDATIONS

Illustration 1 Entry Points for Impact Enterprise Development

Balance Legal Recognition & Flexibility Take Cues from EU SBI & Sistema B Increase Procurement Policies

Policy and Regulatory Environments

Build into Core Business & Programs Create Philanthropic Industry Products Support Research & Knowledge Management Develop Joint Donor Efforts Reach Consensus on Definitions & Needs Provide Patient Capital Foster Capacity Support & Innovation Support Intermediaries Fund Experimentation & Allow for Failure Facilitate Networks & Investment Partnerships

Impact Enterprise Donors

Pioneer Philanthropy

Shift to Include Early Stage Cultivate Investors & Educate Them Transcend Academic Incubation Leverage & Balance State Funding Encourage Incubator Sustainability

Incubators

Clear Goals & Expectations Focus on Scaling Methodology & Tools Support Experimentation & Cross-learning Train Portfolio Managers Offer Consolidation and Growth Grants

Scaling

Use Grants with Loans & Equity Reduce Risks Through Capacity Track Record Through Intermediaries Reconsider Expectations of Return Build Secondary Market for Early Stage

Mixed Financial Instruments Impact Investment

Provide Legal & Investment Guides Develop & Expand Incubators & Accelerators Increase Profile of the Region Promote Emergence of New Funds

Impact Enterprise Development

no free ride: sowing the seeds of impact enterprise. summary of findings & recommendations Prepared by NESsT for The Rockefeller Foundation. Copyright ÂŠ 2012 NESsT.

Sowing the seeds of impact enterprise Summary of Findings & Recommendations

no free ride: sowing the seeds of impact enterprise. summary of findings & recommendations Prepared by NESsT for The Rockefeller Foundation. Copyright ÂŠ 2012 NESsT.